The World's Most Boring Question

What exactly should financial regulators regulate?  A boring question, indeed.  A collorary, not the same question but not quite different, is: what precisely is the role of a central banker?

Stan Fischer, formerly at the World Bank and the IMF and currently Governor of the Central Bank of Israel, takes a crack at answering these two boring but critical questions in an insightful paper entitled "Preparing for Future Crises", delivered to the Club of Central Bankers which met at Jackson Hole last week (see previous post). 

(See papers at http://www.kc.frb.org/home/subwebnav.cfmlevel=3&theID=11163&SubWeb=10660)


Stan, born in Northern Rhodesia (now Zambia), is one of the most insightful central bankers around, albeit quite high on the orthdoxy scale.  His paper gives a pretty good summary of his views, and therefore those of the fiscally orthodox, on these questions. 

A bottoming out does not a recovery make

Jackson Hole, Wyoming, is where the cowboys go to croon beneath the stars.  It's also where the world's central bankers meet to schmooze every August, and sometimes it's not clear who's cowboy, who's central banker.  Sometimes they're both.

Cowboy Bernanke was in a jubilant mood in Jackson Hole at the end of last week, when he took credit -- on behalf of himself and his peers -- for having saved the world from the end of the world, at least from a massive financial meltdown.  "Prospects for a return to growth in the near term appear good,"  said the chairman of the Federal Reserve.  "The outcome could have been decidedly worse."  But cowboy Trichet, who moonlights as the President of the European Central Bank, was less sanguin.  Talk of a return to normal made him feel a little uneasy.  If not queasy.

So, what's happening?  Well, Ben, a bottoming out is not a return to normalcy. Unemployment is still high in the US and Europe and private financial flows to emerging economies -- a key growth factor in these markets -- are still comatose.  Domestic demand in the big economies is still very low as consumers seek to repair their balance-sheets and don't count on returning to their free-wheeling habits any time soon.  What we need, my friends, is a new engine of growth to replace now dead US middle-class consumption driven by excess credit card debt. 

China, can you hear me?

An intriguing question going forward is how these events will shape political outcomes in the near term.  In Japan, the impending loss of power by the LDP -- for the first significant period since 1955 -- probably would have happened anyway, as the party lost credibility long before the financial crisis.  But what about governments falling in Africa?  Abolition of term limits? Unrest in the Middle East?  Has the financial crisis emboldened the Taliban in Afghanistan? How long can Mr. Chavez survive on $75 a barrel oil?  Where will the next coup occur?

So many questions...

Alan Beattie tells us: "Countries do not become rich by accident. They make choices that determine the path their economies take. It is not always clear which is the right path at any given point, though some general rules can be drawn. But the countries that succeed are those that are flexible enough to learn from experience and that do not become captured by groups whose interests are sharply at odds with those of the country as a whole." (False Economy, 2009.)

OK then, if economic outcomes are path-dependant, that means that small decisions taken by countries can, over time, become amplified by intermediate outcomes and further wrong decisions. Examples abound. Madagascar in the post-independence 1960s during the First Republic under President Tsiranana, was a middle income country comparable to Thailand. With hugely fertile farmland, a rich ecosystem and strong indigenous institutions, it had all the signs of becoming an emerging economy. Development outcomes, like maternal and child mortality, were very good; people were well fed; corruption was non-existant. And yet; and yet... Today Madagascar is among the poorest of the poor, corrupt, unstable, unhappy. Its rich ecosystem is fast disappearing under uncontrolled slash and burn agriculture. It is number 190 in the World Bank ranking of Gross National Income (Atlas Methodology), with under $1.20 per person per day. What happened? The 1972-75 Revolution, the arrival of President Ratsiraka and his clique, nationalization of industy and commerce, realignment with the Eastern Bloc. So many wrong economic decisions taken by groups whose interests were sharply at odds with those of the country as a whole. Thailand, by the way, is ranked 127.

Sierra Leone is number 201 in the same world ranking. Yet, at the start of the "Scramble for Africa" in the middle of the 19th Century, Sierra Leone was the last "civilized" outpost before European travelers arrived in the Dark Continent. Contemporary writers referred with admiration to its university, its schooling system, efficient administration, well educated population, all of African origin. But with so many bad decisions over the years, today it is a country with weak institutions, a poor population, lacking infrastructure, schools, clinics, drinking water.

Are there any wrong decisions being taken by certain rich countries today that they will rue tomorrow? If Alan is right when he says "[T]he countries that succeed are those that are flexible enough to learn from experience and that do not become captured by groups whose interests are sharply at odds with those of the country as a whole", it's difficult not to watch the unfolding healthcare debate in the United States and feel that the country is making a colossal, historic mistake. Already, Medicare (for the aged) and Medicaid (for the poor) eat up as much GDP as the entire UK National Health Service (around 8.5%) but government insurance programs of this kind only cover 27.8% of the US population, whereas the reviled NHS covers 100% of the British population. The overall US healthcare system, at nearly 17% of GDP, is almost twice as costly as the OECD average while healthcare outcomes for American citizens are below those of the OECD. But some groups, in Alan's words, whose interests are sharply at odds with those of the country as a whole, have managed to capture the debate and will ensure that the outcome for the US will be much worse than it need be. It's Madagascar all over again.

The Meltdown

The financial and economic crash of 2008 is turning out to be the worst financial crisis since the 1930s. Its global reach has left practically no country untouched, and it is erasing the past decade of development gains in the emerging world. World industrial production fell by an unprecedented 20% in the fourth quarter of 2008 (annualized rate), and continued to contract in the first half of 2009. GDP fell in all industrialized countries in the last quarter of 2008 and in most over the first half of 2009.  Several large developing economies are also showing GDP compression for late 2008 and early 2009. Estimates are that around 100 million people have been or are being put out of work worldwide. The worldwide destruction of wealth through declines in equity — house values, stocks — is of the order of the GDP of the United States. The Wall Street investment banking sector, as we knew it, has all but disappeared. And commodity prices, recently at an all-time high, have plummeted. By the time the crisis is over, the geopolitical and economic landscape will be quite different to what it was at the beginning of the century.

This post looks at the underlying causes of the crisis; the likely effect on foreign direct investment (FDI); and makes some observations concerning the provision of political risk insurance (PRI) in the new environment. The crisis itself is multi-dimensional: like Russian Matryoshka dolls that fit inside one-another, the unfolding of each facet of the crisis reveals another imbalance and correction that adds to the misery.

The financial crisis

The innermost doll of the unfolding drama is the financial crisis. Conventional wisdom puts the blame on the "subprime mess" — the collapse of the subprime mortgage market and housing prices in the United States. But at the heart of the financial crisis is a toxic cocktail of loose monetary policy in the United States and Europe resulting from the cut in interest rates following the September 11, 2001 terrorist attacks (the US Federal Reserve lowered interest rates close to 1% at the end of 2001, and kept them low for three years); a global savings glut resulting from the enormous surpluses in countries like China and the oil producers in the Gulf; and unfettered financial sector innovation, unchecked by financial regulators, leading to a slew of new financial products that seemed to provide the chimera of high yields at low or close to zero risk.

In this crisis, excess liquidity did what excess liquidity has always done in past financial crises; it led to massive, unsustainable leverage — excessive levels of debt — throughout the US and European economies. At the collapse of Bear Stearns and its sale to JP Morgan at $2 per share on March 16, 2008, the investment bank's leverage (the ratio of its outstanding loans to its capital) stood at 38; and when Lehman Brothers filed for bankruptcy under Chapter 11 on September 15, 2008, its leverage was around 35. A good prudential regulation rule of thumb is that banking leverage should not exceed a ratio of about 10 or 12 (depending on the nature of its capital). This leverage was spread throughout the economy: firms had borrowed excessively to maximize returns to the equity holders; households had bought houses beyond their means, taken out home equity lines of credit, and racked up excessive credit card debt.

When the unwinding of excess liquidity commenced, its effects snowballed throughout the economy. In early 2007, home prices started to fall in key markets like the United States and the UK. The first shoe to drop of the impending crisis was on June 22, 2007, when Bear Stearns bailed out two of its hedge funds. The snowball starts to roll in August, 2007: on August 9, BNP Paribas suspends three of its funds, Countrywide Financial (the largest US mortgage lender) exhausts its lines of credit; and on September 14, 2007, Northern Rock turns for help to the Bank of England. By the third and fourth quarters of 2007, mortgage defaults are rising sharply in the US, particularly in the subprime mortgage segment of the market. In late November Citigroup obtains an injection of capital amounting $7.5 billion from the Abu Dhabi Investment Authority. In January 2008, global equity markets reel; the Fed makes its biggest interest cut ever. On March 16, 2008, Bear Stearns goes under and is sold to JP Morgan. Over the period between late July and early September 2008, Fannie Mae and Freddie Mac (US government sponsored enterprises created to support mortgage finance) are placed in government conservatorship of the Federal Housing Finance Agench (FHFA). September is the "winter of discontent" for the markets; investors start to lose confidence and firms start to have difficulty in raising finance. Mid-September is a key turning point: On September 15 Merrill Lynch sells itself to Bank of America, Lehman Brothers files under Chapter 11, and later in the week AIG (the largest insurance company in the world) needs to be bailed out by the Fed. The financial crisis is now in full swing.  How have the mighty fallen.

The credit crisis

If the financial crisis is the first Russian doll, the second is the credit crisis. And whereas the financial crisis unfolded over a period of time, the commencement of the credit crisis can be dated quite precisely: September 15, 2008, when the Fed decided not to bail out Lehman Brothers and allowed it to go under. This decision was probably taken by the Fed to reduce the risk of moral hazard in the rest of the financial sector. However, the collapse of a major Wall Street player deemed by the markets to be "too interconnected to fail", rattled banks and financial operators throughout the economy. This act brought home the reality of counterparty risk: what are the consequences if the counterparty of a valid transaction suddenly fails. On the news of the Lehman Brothers collapse, interbank credit markets froze and interbank rates rose to unprecedented levels. The TED Spread (difference between the Libor interest rate and Treasury bill rate at the same maturity), which is an indicator of confidence in the credit markets, rose from its normal 0.5% to 4.5% in October 2008. Since that time the availability of credit throughout the economy (trade finance, bank syndications, availability of lines of credit for firms) has declined sharply throughout the US and Europe, and margins over central bank lending rates have risen sharply. To date, credit markets are only now beginning to return to normal after massive programs of support from governments providing guarantees for commercial paper issued by banks and large corporates; but there has clearly been an overall improvement since October 2008.

The credit crisis is a powerful multiplier from the financial crisis to the rest of the economy. Nearly all firms rely on credit to function; if this credit becomes more expensive, firms become less profitable and rein in production at the margin. If this credit disappears, the firm goes under. The massive deleveraging in the financial sector has already made credit much scarcer and more expensive in the economy. But the credit crisis, which has led to lines of credit to firms not being renewed, supplier credit being curtailed, and projects not being financed, has triggered a tsunami throughout the economy.

Governments have reacted to the credit crisis by providing guarantees for paper issued by banks and large corporates, to reduce the perception of counterparty rsk. This has for the most part been quite successful so far. But as banks scale back their lending to adjust to their reduced capital base, the decrease appears to have hit trade credit disproportionately hard which is having a significant impact on global trade.

The economic crisis

The third doll is the economic crisis, which is unfolding as this is being written. The massive reduction in demand has led to the biggest single quarter decline in rich country GDP in a quarter century in Q4, 2008. In rich countries automobile sales have plummeted, housing starts are at an all-time low, and discretionary consumer spending has frozen as households take a prudent stance on consumption. Unemployment has started to rise as factories lay off workers or shutter their doors.

The economic crisis in industrialized countries has had rapid impact on developing countries, as demand for manufactures and commodities has plummeted, and import volumes have declined in response to lower consumer demand. Containers of unsold goods have piled up in both exporting and importing ports and charter rates for shipping have declined. By fourth quarter 2008 this increase in inventories triggered a fall in world industrial production by an unprecedented 20%, and GDP fell in all industrialized countries.
The economic crisis is having an impact on everyone everywhere, even in countries that have financial sectors with conservative leverage ratios and relatively modest recourse to private financial flows. It is leading to higher unemployment, cuts in public spending on social programs and loss of household wealth. It is difficult to estimate the social impact at this point but it is without doubt that the curtailment of programs worldwide is leading to an increase in poverty and a decline in living standards.

Private financial flows to developing countries

These nested crises have not left financial flows to the developing world untouched. In 2007, private financial flows to developing countries were close to $1 trillion. Developing country investments were seen as having better yields than those in industrialized countries, and just as excess liquidity pumped money into real estate and exotic synthetic financial products, it fuelled a very significant expansion of investment in the emerging world. High liquidity and an abundance of capital compressed sovereign risk premiums and brought the cost of financing to emerging markets down to hitherto unforeseen levels, as overall volumes of financing were rising.

The combination of the financial and credit crises has brought this phenomenon into reverse. Flows from private creditors and banks to emerging markets have reversed and they are now pulling money out of the developing world, as they deleverage in an effort to shore up their balance sheets. At the same time, direct investment in the developing world is declining, following the reduction in cross-border debt financing, as projects that rely on syndicated loans and other complex debt structures — such as infrastructure and extractive industries — can no longer close their financing plans. These trends have led to a massive decline in private sector financing for development. The Institute of International Finance estimates that private flows to emerging economies will decline to no more than $165.3 billion in 2009, compared to $465.8 billion in 2008 and $928.6 billion in 2007 (see table, below).

Also, as private financing has dried up for emerging economies, the cost of this financing has risen quite dramatically. This is partly due to a shifting of the supply-demand curve for finance as supply has become scarcer; but also because the rediscovery of risk, and more rational pricing. So developing countries are being hit by a triple effect: decline in exports to rich countries; a decline in financial flows from rich countries; and more expensive financing.

Emerging Market Economies' External Financing billions of U.S. dollars
	2006	2007	2008e	2009f
Current account balance	383.9	434.0	387.4	322.8
External financing, net:
Private flows, net	564.9	928.6	465.8	165.3
Equity investment, net	222.3	296.1	174.1	194.8
Direct investment, net	170.9	304.1	263.4	197.5
Portfolio investment, net	51.5	-8.0	-89.3	-2.7
Private creditors, net	342.6	632.4	291.7	-29.5
Commercial banks, net	211.9	410.3	166.6	-60.6
Nonbanks, net	130.7	222.2	125.1	31.1
Official flows, net	-57.5	11.4	41.0	29.4
IFIs	-30.4	2.7	16.6	31.0
Bilateral creditors	-27.1	8.7	24.3	-1.6
Resident lending/other, net1	-336.5	-425.3	-449.8	-271.6
Reserves (- = increase)	-554.8	-948.7	-444.3	-245.9

e = estimate, f = IIF forecast
1Including net lending, monetary gold, and errors and omissions

Source: Institute of International Finance, Capital Flows to Emerging Market Economies, January 27, 2009

Effects on the political risk insurance sector going forward

In recent months we have seen two diametrically opposed trends in the political risk insurance sector: first, an overall decline in demand for PRI, as financial flows have dried up; and second, a significant increase in rates as the reality of risk has returned with a vengeance. How these will play out over the coming months is not yet clear, although for MIGA itself, we can see a clear decline in overall volumes of PRI provided, resulting directly from the difficulty in closing financing on complex investments in developing countries, with a very significant shift away from support to infrastructure toward banking recapitalization.

Going forward, we expect that growth FDI will resume, probably starting from a lower base than we have seen in recent years. We also expect that perceptions of risk will return to their historical averages. These two trends will translate in increased demand for PRI, probably associated with higher premiums. On the opposite side of the coin, history teaches us that severe economic disruption triggers political turmoil; the period of the 1930s is a stark case in point of this connection.

This leads us to the $64,000 question: are we to expect an increase in the number of political events -- coups, expropriations, riots, unilateral contract modifications, currency disruptions -- leading to claims in the coming months and years?

Emerging market investments and risk

After falling off its bicycle, the world is picking itself up and brushing off its bloodied knees. What a ride! What a fall! The chain is off, the spokes are twisted, world central bankers and regulators are trying to get the cogs lined up to get the thing working again. It's a different world now, and who knows what the post-crisis global economy will look like?


We are pulling through the biggest financial crisis since the 1930s. The economic and financial landscape is going to be very different going forward. Who will win, and who will lose? Which industries will be on the up, and which down? Which emerging economies will submerge once again, their heads falling below the poverty waterline, and which will use the crisis to leapfrog to the next development stage?

This blog will track observations and thoughts on emerging economic trends over the coming months, with a particular focus on investment in emerging economies and political risk. It is based on decades of experience in development finance and on day-to-day experience in risk mitigation for investors in emerging economies. I hope it will be a learning experience as much for the author as for any readers, because we are moving into choppy waters and who knows what the world will look like in a year or five?